What you need to know about the latest developments surrounding US chipmakers and Huawei

The US Commerce Department has placed Huawei and 68 of its affiliates on its Entity List, thereby restricting its ability to procure semiconductors from its US suppliers.

The drop in share prices of US chipmakers is likely excessive, as most of them has an insignificant amount of exposure to Huawei.

We remain positive on the long-term prospects of the semiconductor industry, and urge investors to seize this opportunity to add to their positions.

Negative impact felt by US chipmakers as ban on Huawei kicks in

Two weeks ago, the US Commerce Department announced that it has placed Huawei and 68 of its affiliates on its Entity List, a move that restricts Huawei’s ability to purchase critical components from US firms to manufacture its products. US companies that wish to conduct business with companies on the Entity List are required to obtain a special license before doing so.

This comes after President Trump signed an executive order barring US companies from using telecoms equipment manufactured by Huawei, citing national security risks. There has been concerns that hardware manufactured by Huawei could possibly be used for spying, although evidence has yet to be found. The effect of the ban was far-reaching, as even non-US companies, such as Panasonic and ARM, announced that they will be suspending business relations with the embattled Chinese firm.

Huawei is the world’s largest networking gear maker, and is widely considered to be the leading player in 5G networking solutions. Besides the reliable and cheap networking equipment that the company is known for, it also produces a variety of other products ranging from smartphones to fitness trackers. As a major producer of electronic goods, the success of Huawei largely depends on its ability to procure semiconductors, the backbone of all electronic devices.

Unfortunately for Huawei, China currently does not possess the capability to produce high-performance chips required for modern electronics. Much of that capability resides with US firms, most of which are the goliaths in the global semiconductor industry. As a result, Huawei and most of its peers are heavily reliant on US chipmakers for their chip supply.

(Related Article: Why we believe the semiconductor industry will perform well over the next decade)

It is estimated that Huawei purchases roughly 20% of their chips from US-based firms each year, while the remainder is sourced from mainland China, as well as other markets, such as South Korea and Taiwan. Looking at how Huawei’s supply chain is so closely intertwined with US chipmakers, it is not surprising that the Huawei ban had a negative impact on their share prices. Since the ban was implemented, the Vaneck Vectors Semiconductor ETF (NYSE.SMH) has tumbled by almost -9% (as of 27 May 2019).

Figure 1: Share prices of US chipmakers dived as the news of Huawei’s ban broke

While the latest development has cast a shadow over the future of US chipmakers, we remain positive on the long-term prospects of the semiconductor industry. Here’s why.

Most US chipmakers do not have significant exposure to Huawei

We begin by analysing Huawei’s supply chain, paying particular attention to its US chip suppliers, and how much revenue exposure each supplier has to Huawei. Out of the 25 constituents in the VanEck Vectors Semiconductor ETF (SMH), only seven companies have more than 4% revenue exposure to Huawei, the largest being Qorvo at 15% (Table 1). Intel, the company with the highest weighting in SMH, has an exposure of just 0.17%. On a weighted-average basis, the ETF's overall exposure to Huawei is only 2.6%.

Moreover, if we exclude TSMC from our analysis, SMH’s revenue exposure to Huawei drops to a mere 1.98%. While it remains unclear if TSMC – a non-US company – is affected by the US ban, the company has said that it will maintain supplies to Huawei for the time being. As such, we think the Huawei ban should have limited impact on TSMC’s earnings in the near-term.

Table 1: SMH constituents do not have significant exposure to Huawei

Considering the fact that SMH constituents do not have significant revenue exposure to Huawei, we believe that the recent sell-off is most probably a knee-jerk reaction by short-sighted investors who are reacting based on market sentiment rather than an actual deterioration in fundamentals.

China still reliant on US-made chips in the foreseeable future

The latest restrictions on Huawei, as well as those placed on ZTE in 2018, revealed just how vulnerable China is when it comes to the production of semiconductors. The decision to ban US companies from doing business with ZTE nearly bankrupted the company, until President Trump stepped in to strike a last-minute deal. Although Huawei may be in a better shape compared to ZTE due to its extensive efforts to develop its own semiconductors, it is still far from being completely self-sufficient.

Following the latest episode, China will most likely double down on its efforts to develop its own domestic semiconductor supply chain so as to reduce its reliance on the US. If successful, it will certainly threaten the long-term competitiveness of US semiconductor firms – another market concern that is weighing on the share prices of US chipmakers.

While such concerns are legitimate, it is worth noting that semiconductors are some of the most complex products to design and fabricate in the world, and the success of US-based firms in semiconductor manufacturing is not something that can be replicated overnight. It is the fruit of thousands of hours and billions of dollars spent on research and development over the decades. Thus, it could take China several years or even decades just to be on par with the US.

Till that happens, Chinese electronics manufacturers like Huawei will have no choice but to rely on the US for their supply of chips.

Long-term growth story unaffected by recent developments

While we remain hopeful of a breakthrough in US-China trade negotiations, we believe the long-term growth story of semiconductors remains intact. Despite the escalating trade war tensions, global semiconductor sales is still well on track to hit a record high of USD 500 billion by 2020, driven by the widespread demand for semiconductors, which are essential components of all electronic devices, including future applications such as 5G and the internet of things.

As technology advances with each passing day, manufacturers need to constantly source for cutting-edge chips that can meet the lofty requirements of modern day technology. Until China gets up to speed with its semiconductor technology, the US’s lead in semiconductor manufacturing remains unassailable, and this certainly bodes well for the US semiconductor industry and the Vaneck Vectors Semiconductor ETF (NYSE.SMH).

(Related Article: 3 Reasons Why You Should Invest In The Semiconductor Industry)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.